After
months of adamant official denial of any potential
threat of the subprime mortgage meltdown spreading to the global
financial
system, the US Federal Reserve (Fed) on Friday, August 17, a mere 10
days after
declaring market fundamentals as strong and inflation as its main
concern, took
radical steps to try to halt financial market contagion worldwide that
had
become undeniable. The Wall Street Journal reports that the emergency
measures
were hastily taken to promote what the Fed publicly referred to as “the
restoration of orderly conditions in financial markets.” The
telling words were “restoration of orderly
conditions” in a market that had failed to function orderly. The Fed
let the
market know that it has shifted to panic mode.

Restoring
Disorderly Market Conditions

The WSJ reports that the crisis of
disorderly conditions
began two days earlier on August 16 in London
where $45.5 billion of short-term commercial paper issued by US
corporations
overseas was maturing but traders had difficulty selling new paper to
roll them
over as they normally would have by noon
time in London, or 7 a.m. in New
York.
Demand for commercial paper had dried up suddenly in a tsunami of risk
aversion.
Less than half of the paper was eventually sold at distressingly high
interest
rates by the end of the trading day. At 7:30
a.m.
in New York, Countrywide
Financial Corp., the largest home mortgage lender, announced that it
was
drawing all of its $11.5 billion of bank credit lines because it had
difficulty
rolling over its commercial paper IOU.

By noontime in New
York,
near the end of the trading day in London,
the dollar fell against the yen by 2% within minutes to cause traders
to rush
to unwind their yen carry trade positions. Money rushed into 3-month US
Treasury bills, pushing the yield down from 4% to 3.4%, sharply
widening the
spread with corporate commercial paper, with some GE paper moving as
high as
9.5%, which in normal times would be close to the Fed Funds rate which
now
stands at 5.25%. By evening, Chairman Bernanke of the Fed convened a
conference
call of board members. The next morning, Friday, August 17, the Fed
capitulated.

To ward off
a market seizure, the Fed cut the discount rate
at which cash-short US banks and thrift institutions can borrow
directly from
the central bank as a lender of last resort. The Fed announced that it
would grant
banks and thrifts such loans from its discount window against a liberal
range
of collateral, including technically unimpaired triple-A rated subprime
mortgage securities of uncertain market value and liquidity. The
discount rate
was cut from 6.25% to 5.75%, making it merely 50 basis points above the
Fed
Funds rate target, half of the normal spread for a neutral monetary
policy. The
Fed also extended the period for loans at the discount window from one
day to
up to 30 days, renewable by the borrower. These changes “will remain in
place
until the Federal Reserve determines that market liquidity has improved
materially” and “are designed to provide depositories with greater
assurance
about the cost and availability of funding.”

The New York Fed, which has the responsibility
of operating
the Open Market Committee to keep inter-bank rates close to the Fed
Funds rate target
by buying or selling securities and by making overnight loans in the
repo
market (see: The
Repo Time Bomb),
had injected substantial amounts of liquidity, $62 billion up to the
time of
the discount rate cut, by such means into the banking system in
previous days. Earlier,
the effective Fed Funds rate had traded at 6%, 75 basis points above
Fed
target, as banks demanded higher rates to lend to each other.

The Fed
then convened an extraordinary conference call for major money center
banks to
explain its latest moves. It tried to encourage banks to use the
discount
window, saying to do so would be a “sign of strength” under current
circumstances, not a sign of distress as in normal times where banks
are conventionally
reluctant to use the discount window, fearing that going to the Fed for
cash
might be interpreted by the market as a sign a distress.

The Fed said in a policy statement on the same day of the
unusual discount window moves that financial market conditions had
deteriorated
to the point where “the downside risks to growth have increased
appreciably”. The
Fed said it is monitoring closely market situations and is “prepared to
act as
needed to mitigate the adverse effects on the economy arising from the
disruptions in financial markets”.

The language of the 2007 Fed statement is an echo of
Greenspan-speak. Notwithstanding his denial of responsibility in
helping
through the 1990s to unleash the equity bubble, Alan Greenspan, the
then
Chairman of the Fed, had this to say in 2004 in hindsight after the
bubble
burst in 2000: “Instead of trying to contain a putative bubble by
drastic
actions with largely unpredictable consequences, we chose, as we noted
in our
mid-1999 congressional testimony, to focus on policies to mitigate the
fallout
when it occurs and, hopefully, ease the transition to the next
expansion.”

I wrote in AToL on September 14, 2005: “Greenspan's formula of
reducing market regulation by substituting it with post-crisis
intervention is
merely buying borrowed extensions of the boom with amplified severity
of the
inevitable bust down the road. The Fed is increasingly reduced by this
formula
to an irrelevant role of explaining an anarchic economy rather than
directing
it towards a rational paradigm. It has adopted the role of a cleanup
crew of
otherwise avoidable financial debris rather than that of a preventive
guardian
of public financial health. Greenspan's monetary approach has been
"when
in doubt, ease". This means injecting more money into the banking
system
whenever the US
economy shows signs of faltering, even if caused by structural
imbalances
rather than monetary tightness. For almost two decades, Greenspan has
justifiably been in near-constant doubt about structural balances in
the
economy, yet his response to mounting imbalances has invariably been
the
administration of off-the-shelf monetary laxative, leading to a serious
case of
lingering monetary diarrhea that manifests itself in runaway asset
price
inflation mistaken for growth.”
(http://atimes01.atimes.com/atimes/Global_Economy/GI14Dj01.html)

Chairman Bernanke has now summoned his own clean-up team
into action. The Fed hopes that by assuring banks that they can now
access cash
on less punitive terms from the Fed discount window, collateralized by
the full
“marked to model” face value of mortgage-backed securities, rather than
the
true distressed value as “marked to market”, for which they could find
no
buyers at any price in recent weeks as the market for such securities
has
seized up, it can jumpstart market seizure for mortgage-backed
commercial paper
and securities.

The Fed announced the discount rate and maturity changes a
day after a video conference of its Open Market Committee in which the
emergency
action was “unanimously” endorsed by all voting committee members,
except
William Poole, president of the St Louis Fed, who had argued publicly a
few
days earlier against an emergency rate cut short of a “calamity” and
who did
not take part in the vote.

By its emergency actions, the Fed conceded the existence of a
market “calamity”. Equity markets around the world interrupted their
week-long
losing streak and rose reflexively on the news on the last trading day
of the
week, albeit doubt remains on the prospect that such market adrenaline
is
sustainable. The Dow Jones Industrial Average (DJIA) gained 233.30
points, or
1.8%, edging back to 13,079 on hope that the Fed has now finally come
to the
rescue of a collapsing market.

Still, the yield on the two-year US Treasury note fell 4
basis points to 4.18%, signaling continuing risk aversion in the credit
markets
and investor flight to safety, not even just to quality. Fed Funds
futures indicate
that the market expects several quarter-point cuts from the current
5.25 per
cent by the end of the year to keep the troubled economy afloat.

Unsustainable
Adrenaline

By Monday, August 20, the adrenaline already wore off and
the DJIA turned negative by noon
on
the first trading day after the Fed emergency actions. The flight to
safety
pushed the 3-month treasury yield to 2.5% at one point. It can be
expected that
sharp volatility in the equity markets will continue as announcements
of
assurance are issued by the Fed, the Treasury and key Congressional
Committee
chairmen to temporarily boost the market on false hopes only to be
brought back
down later to reality. The market is casting a vote of no confidence in
the
Fed’s ability to save the market. At best, the Fed can slow down the
credit meltdown
by extending it out into years rather letting the market execute a
needed catharsis.
It is not a scenario preferred by true free marketers.

No doubt the Fed has an arsenal of offensive monetary tools
at its disposal. But just like the war on terrorism in which all the
guns of
the Pentagon can have no effect unless the military can find real
terrorist
targets, the Fed’s monetary tools remain useless unless the Fed knows
where to intervene
effectively. Just as terrorists morph into the general population to
make themselves
difficult to identify, the problem with structured finance is that by
transferring unit risk to systemic risk, it deprives the Fed of
effective
targets to intervene on a systemic re-pricing of risk. When contagion
has
already spread risk aversion to all vital components of the credit
market,
containment is no longer an effective cure. Financial health will
continue to
decline in the entire system until the risk appetite virus works its
natural
cycle. Excess liquidity is like a drug addiction. It cannot be cured
with
another stronger addictive drug by adding more liquidity. What the Fed
is trying
to do is not merely to restore market liquidity, but to preserve excess
liquidity in the market. It is trying to avoid a crisis by setting the
stage
for a bigger future crisis.

Low Interest Rates
Hurts the Dollar

The problem with the single-dimensional prognosis on the
curative power of policy-induced falling interest rates on the ailing
economy is
that it ignores the adverse impact such interest rate cuts will have on
the
exchange value of the dollar which has already been falling in recent
years beyond
levels that are good for the economy.

How the Discount
Window Works

Eligible depository
institutions are allowed to borrow against high-grade collaterals
directly from
the Fed’s discount window to meet short-term unanticipated liquidity
needs. One
category of these collateralized loans, termed “adjustment credit,”
comprises
loans that are usually overnight in maturity and are made at an
administered discount
rate. However, banks traditionally only make sparing use of the
discount window
for adjustment credit borrowing. The discount window is also used for
seasonal
borrowings, mostly associated with agricultural production loans, and
for
“extended credit” for banks with longer-maturity liquidity needs
resulting from
exceptional circumstances.

The most potent power bestowed by Congress on the Federal
Reserve System is the setting of the discount rate. Raising the
discount rate
generally increases the cost of bank borrowing and slows the economy,
while
lowering it stimulates economic activity, since banks set their loan
rates
above the discount rate, and not by market forces. In contrast, while
the Fed
Funds rate is also set by the Fed, it is implemented by the Fed Open
Market
Committee participating in the repo market to keep the short-term rate
close to
the Fed’s target. The discount rate affects cost of funds without
affecting
money supply while the Fed Funds rate changes the level of the money
supply.
Both rates are set by fiat by the Fed based on the Fed’s best judgment
within
its theoretical preference. The difference between the two rates is
that the
discount rate is set independently of market forces while the Fed Funds
rate
acts through market forces. With the discount rate, the Fed sets the
rules of
the money market game while with the Fed Funds rate, the Fed acts as a
key money
market participant.

In response to the October 19, 1987 crash,
Alan Greenspan, as the newly appointed Fed chairman, lowered the Fed
Funds rate
from 7.25% set on September 4, 1987, 45 days before the
crash, to 6.5% by early
February, 1988, while keeping the discount rate at 6%. On February 23,
the Fed
increased the spread to 3-1/8 percentage points with the Fed Fund rate
at
9-5/8% and the discount rate at 6-1/2%. The
Fed then lowered both rates gradually to 3% with zero spread by September 4, 1992
below the
inflation rate for August which was 3.15%. The negative interest rate
launched the
debt bubble that first fueled the tech bubble which peaked on March 10, 2000
and burst in
subsequent months when Greenspan raised the Fed Funds rate to 6.5% on
May 16
and the discount rate to 6% before lowering rates starting January 3, 2001
to save the
market. By November
6, 2002, the Fed Funds rate was 1.25% and the
discount rate was 0.75% to fuel the housing bubble which was also
turbocharged
by subprime mortgage securitization. That housing bubble is now
bursting.

Until January
3, 2003, the
discount rate normally was set at 25 to 50 basis points below the Fed
Funds
rate. On that historic day, the discount
rate was reset by policy to be 100 basis points above the Fed funds
rate. On June
25, 2003, when the
Fed Funds rate was at a historical low of 1%, the discount rate was set
at 2%
when the inflation rate was 2.11%. Negative interest rate expanded the
housing
bubble in a frenzy rate.

Before 2003, to
prevent banks from exploiting the spread between the Fed Funds rate and
the then
lower discount rate, the Fed required banks to document any need for
funds as
appropriate to the discount facilities’ policy intent. Discount window
loans would
not be granted as bridge loans to enable banks to wrap up planned
investment or
to exploit loan opportunities beyond the bank’s normal liquidity range.
In
addition, banks were expected to have first exhausted all other
reasonable
sources of credit before borrowing from the discount window and should
expect
to face greater regulatory scrutiny if they borrow at the window too
frequently.
These non-pecuniary penalties made many banks reluctant to borrow at
the
discount window for adjustment credit, concerned over a perceived
“negative
signal” that such action would send. The volume of borrowed reserves
was generally
less than 1% of total reserves.

Setting the
discount rate above the federal funds rate target was an important
change in
the administration of the discount window to allow for more reliance on
explicit market pricing to determine the volume of discount window
borrowing
and to remove the perceived stigma to discount borrowing. Eligibility
requirements would be streamlined and rendered consistent with reliance
on the
discount window as a relatively unfettered source of liquidity for
financially
sound banks during tight money market conditions that would otherwise
result in
a spike in the Fed Funds rate.

The initial
proposal set a cap for the discount rate at 100 basis points above the
federal
funds rate target. Historically, this cap would have been breached by
the
average daily federal funds rate only about 1% of the time, with
roughly half
of those days coming on bank settlement days. However, the frequency
with which
individual trades throughout the day would have exceeded the cap was
significantly
higher. The closing Fed Funds rate would have exceeded this cap
approximately
4% of the time. As banks adjusted their reserve management practices
under the
new operating procedures, this cap became binding more frequently than
history
would suggest. In any case, the average daily cost of federal funds to
banks
should be reduced and the Federal Funds rate should remain closer to
the Fed’s
target.

This rule change on
the discount rate was expected to have several benefits. First,
providing a cap
on the federal funds rate by endogenously supplying reserves to meet
high
periods of demand should reduce interest rate volatility. This might
become
more significant as continual financial innovation would otherwise
further
reduce banks’ required reserves and render the demand for reserves more
interest inelastic, as required clearing balances assume a larger share
of the
total demand for reserves. Second, the simplification of discount
window
borrowing procedures should lead to reduced administrative costs and
streamline
operations. Third, these simplifications also will help clarify the
intent of
individual discount window regulatory decisions, since less subjective
assessment is required. Finally, monetary policy could be rendered more
effective, to the extent that the discount rate could become a tool for
capping
the federal funds rate. This cap could be adjusted to keep the Fed
Funds rate
close to the target value, where “close” is determined as a matter of
monetary
policy decisions that reflect current market conditions. In Fed
newspeak, the
“discount” rate then becomes more expensive than full price inter-bank
borrowing.

Primary and
Secondary Credit

On January 9,
2003, the Fed adopted
this procedure and introduced two levels of discount rate: primary and
secondary. Primary credit is available to generally sound depository
institutions on a very short-term basis, typically overnight, at a rate
above
the Federal Open Market Committee’s target rate for federal funds.
Depository
institutions are not required to seek alternative sources of funds
before
requesting occasional short-term advances of primary credit. The Fed
expects
that, given the above-market pricing of primary credit, institutions
will use
the discount window as a backup rather than a regular source of
funding. In
reality, as the debt economy developed, banks were able to use the
discount
widow without regulatory scrutiny to fund planned investment or loan
opportunities that yielded returns higher than the punitive discount
rate. The
Fed in effect became a funding agency of last resort for the debt
bubble.

Primary credit may
be used by banks for any purpose, including financing the sale of
federal
funds. By making funds readily available at the primary credit rate
when there
is a temporary shortage of liquidity in the banking system, thus
capping the
actual federal funds rate at or close to the primary credit rate, the
primary
credit program complements open market operations in the implementation
of
monetary policy.

Primary credit may
be extended for up to a few weeks to depository institutions in sound
financial
condition that cannot obtain temporary funds in the market at
reasonable terms;
normally, these are small institutions. Longer-term extensions are
supposedly subject
to increased administration. It is not clear if the Fed’s new term of
up to 30
days involves increase administration to subject borrowing banks to
face
greater regulatory scrutiny.

Secondary credit is
available to depository institutions not eligible for primary credit.
It is
extended on a very short-term basis, typically overnight, at a rate
that is
above the primary credit rate. Secondary credit is available to meet
backup
liquidity needs when its use is consistent with a timely return to a
reliance
on market sources of funding or the orderly resolution of a troubled
institution. Secondary credit may not be used to fund an expansion of
the
borrower’s assets. The secondary credit program entails a higher level
of
Reserve Bank administration and oversight than the primary credit
program. The
Fed will require sufficient information about a borrower’s financial
condition
and reasons for borrowing to ensure that an extension of secondary
credit is
consistent with the purpose of the facility.

Effect of Discount
Borrowing Controversial

Discount window borrowing
is sensitive to the spread between the Fed Funds rate and the discount
rate. As
the spread narrows, discount window borrowing can be expected to
increase. Hence,
discount window borrowing would offset, at least in part, the effect of
open
market operations on reserve supply. The effect of this feature of
discount window
borrowing remains controversial even after an indeterminate debate in
1960 among
economists on whether the discount mechanism offsets, as argued by
Milton Friedman,
or reinforces, as counter-argued by Paul Samuelson, the monetary policy
objectives of the Fed.

Discount Borrowing
Stigma

During the early
1990s, borrowing from the discount window fell significantly, averaging
only
$233 million, even though this was a period of banking system stress.
Stavros
Peristiani, Assistant Vice President in the Banking Studies Function at
the
Federal Reserve Bank of New York, whose
primary areas of research include housing finance, mortgage-backed
securities, bank mergers and acquisitions, discount window borrowing,
and
initial public offerings, argues that
this decline may have been due to banks refraining from requesting
discount
loans because of the perception that it would send a negative signal to
the
Federal Reserve, bank supervisors, and eventually the market at large.
Even
when banks’ financial conditions improved in the mid-1990s, banks
remained
reluctant to borrow from the Fed.

Partly to address
this reluctance, the Fed replaced its adjustment and extended credit
programs
with the new primary and secondary credit facilities. Now, banks in
good
financial condition could borrow from the Federal Reserve capped at 100
basis
points above the Fed Funds rate target. The above-market price of funds
serves
as a rationing mechanism that dramatically reduces the need for
supervisory
review of the potential borrower. Because use of the new primary credit
facility would not necessarily imply anything negative about a
borrower, banks
should be more willing to use the facility if market or bank-specific
conditions warrant. In fact, since the implementation of this new
facility,
banking supervisors have specifically announced that “occasional use of
primary
credit for short-term contingency funding should be viewed as
appropriate and
unexceptional by both [bank] management and supervisors.” Still, banking being a traditionally
conservative industry, such stigma persists about discount window
borrowing. The
above-market price of the discount rate has been cut on August 17, 2007
by the
Fed by half from its100 basis points cap to 50 basis points over the
Fed Funds
rate target to facilitate discount borrowing had to be qualified with a
public
repeat of Fed policy that such borrowing does not reflect weakness in
the
borrowing banks. Yet the cut in the discount rate reflect weakness in
the
entire banking system, a message not missed by astute market
participants.

When a bank borrows from the Fed’s discount window, it
increases the funds it has in its reserve account held at the Fed,
which the
bank can apply towards meeting its reserve requirement. Thus, ceteris
paribus,
one would expect that when required reserves are higher, discount
window
borrowing would be higher.

Reserve
requirements are the amount of funds that a depository institution must
hold in
reserve against specified deposit liabilities. Within limits specified
by law,
the Federal Reserve Board of Governors has sole authority over changes
in
reserve requirements. Depository institutions must hold reserves in the
form of
vault cash or deposits with Federal Reserve Banks. The dollar amount of
a
depository institution’s reserve requirement is determined by applying
the
reserve ratios specified in the Federal Reserve Board’s Regulation D to
an
institution’s reservable liabilities which consist of net transaction
accounts,
non-personal time deposits, and euro-currency liabilities.

Since December
27, 1990, non-personal
time deposits and euro-currency liabilities have had a reserve ratio of
zero.
The reserve ratio on net transactions accounts depends on the amount of
net
transactions accounts at the depository institution. The Garn-St
Germain Act of
1982 exempted the first $2 million of reservable liabilities from
reserve
requirements. This “exemption amount” is adjusted each year according
to a
formula specified by the act. The amount of net transaction accounts
subject to
a reserve requirement ratio of 3% was set under the Monetary Control
Act of
1980 at $25 million. This “low-reserve tranche” is also adjusted each
year. Net transaction accounts in excess of the
low-reserve tranche
are currently reservable at 10%.

Reserve Balance
Driven by Interbank Payments

The demand for reserve balances is increasingly being driven
by growth in interbank payment activity rather than by minimum reserve
requirements. Interbank payments are processed
over Fedwire, the large-value payment system owned and operated by the
Fed. The
value of aggregate Fedwire payments increased from roughly $1.3
trillion a day
in 1992 to roughly $3 trillion a day in early 2004. These payments are
funded
from an aggregate reserve balance that, as of the first quarter of
2004,
averaged only $11.5 billion.

To facilitate an efficient payment system, the Fed allows
banks to maintain limited negative reserve balances during the business
day at
a low cost, currently 27 basis points at an annual rate, but imposes a
stiff
400-basis-point penalty on negative balances held overnight. Before
2003, hanks
faced with an unexpected negative balance late in the day might have
gone to
the discount window, but they might have remained reluctant. The new
primary
credit facility reduces the perceived stigma of borrowing from the Fed,
and
banks in this situation would borrow from the central bank and pay a
penalty
capped at 100 basis points over Fed Funds rate.

The Clearing House Interbank Payments System (CHIPS) is a
privately operated, real-time, multilateral, payments system typically
used for
large dollar payments, owned by financial institutions, and any banking
organization
with a regulated US
presence may become an owner and participate in the network. The
payments
transferred over CHIPS are often related to international interbank
transactions, including the dollar payments resulting from foreign
currency
transactions, such as spot and currency swap contracts, and Euro
placements and
returns. Payment orders are also sent over CHIPS for the purpose of
adjusting
correspondent balances and making payments associated with commercial
transactions, bank loans, and securities transactions.Since January
2001, CHIPS has
been a real-time final settlement system that continuously matches,
nets and
settles payment orders. In June 2007, CHIPS processed $2.645 trillion
of
payments. CHIPS typically handles about 300 payments ($90 billion in
gross, $36
billion net) in its queue at the end of the day.

Liquidity Risk in
the Interbank Payment System

Liquidity risk is
the risk that the financial institution cannot settle an obligation for
full
value when it is due even if it may be able to settle at some
unspecified time
in the future. Liquidity problems can result in opportunity costs,
defaults in other
obligations, or costs associated with obtaining the funds from some
other
source for some period of time. In addition, operational failures may
also
negatively affect liquidity if payments do not settle within an
expected time
period. Until settlement is completed for the day, a financial
institution may
not be certain what funds it will receive and thus it may not know if
its
liquidity position is adequate. If an institution overestimates the
funds it
will receive, even in a system with real-time finality, then it may
face a
liquidity shortfall. If a shortfall occurs close to the end of the day,
an
institution could have significant difficulty in raising the liquidity
it needs
from an alternative source.

Systems that postpone a significant portion of their settlement
activity in
dollars toward the end of the day, such as CHIPS, may be particularly
exposed
to liquidity risk. These risks can also exist in Real Time Gross
Settlement (RTGS)
systems such as Fedwire. Systems or markets that pose various forms of
settlement risk also pose forms of liquidity risk.

CLS Bank based in New York
is an Edge Corporation bank supervised by the Federal Reserve. CLS Bank
is a
multi-currency bank, holding an account for each Settlement Member and
an
account at each eligible currency’s Central Bank, through which funds
are
received and paid. Technical and operational support is provided by CLS
Services, an affiliate of CLS Bank.

CLS Bank, while
eliminating the bulk of principle risk through its
payment-versus-payment
design, retains significant liquidity risk, as funding is made on a net
basis,
and pay-in obligations may need to be adjusted in the event that a
counterparty
is unable to fund its obligations. Other systems, including securities
settlement systems, may also be subject to liquidity risks.

To manage and control liquidity risk, it is important for financial
institutions to understand the intraday flows associated with their
customers’
activity to gain an understanding of peak funding needs and typical
variations.
To smooth a customer’s peak credit demands, a depository institution
might
consider imposing overdraft limits on all or some of its customers.
Moreover,
institutions must have a clear understanding of all of their
proprietary
payment and settlement activity in each of the payment and securities
settlement systems in which they participate.

Clearing balance
requirements represent obligations to hold reserves that are set at the
discretion
of a bank before each reserve maintenance period. Only balances held at
the

Federal Reserve
during the two-week reserve maintenance period are eligible to satisfy
clearing
balance requirements. A bank is penalized for ending any day overdrawn
on its
account at the Fed, as well as for failing to meet its requirements by
the end
of the maintenance period. To obtain the necessary reserves to avoid
these fees
if unable to borrow the necessary amount of reserves from another bank,
a
qualifying bank may borrow reserves directly from the Federal Reserve
at its
discount window facility under the primary credit program, at a rate
typically
set not more than 100 basis points above the target Fed Funds rate.
This spread
between the primary credit rate and the Fed Funds rate target is
generally
viewed as representing a de facto penalty associated with being
deficient. This
penalty has been cut in half on August 18. The Federal Reserve does not
pay
interest on reserves held in excess of requirements. Thus, the
opportunity cost
of holding excess reserves is a bank’s marginal funding cost, which is
represented by the Fed Funds rate.

To provide banks
with some flexibility in meeting their requirements for avoiding these
penalties
and costs, the Fed allows banks to apply excess reserve balances held
in one maintenance
period to meet reserve requirements in the following period, in an
amount up to
4% of reserve requirements in the second period. Similarly, a bank may
end a period
up to 4% short of its reserve requirements and pay no penalty, so long
as it holds
sufficient excess reserves in the following period to offset this
deficiency.

Fed Actions aim at
Mutually Contradicting Objectives

The Federal Reserve action on the discount rate tries to meet
its short-term responsibility to keep financial markets functioning by
injecting funds into the banking system. At the same time, the Fed
tries also
to macro manage the economy in containing inflation by tightening the
money
supply through interest rates increases. For almost a century since its
establishment in 1913, the Fed has been engaged in a continuous battle
between
inflation and economic growth by standing on both sides of the conflict
to keep
a balance. This conflict is a structural malady of market capitalism.
Recurring
economic recessions or depressions lead to asset depreciation or
disinflation
or deflation which can only be cured by currency devaluation which
translates
into inflation. Some economists, including Ben Bernanke, the new Fed
Chairman,
support inflation targeting as a viable monetary policy option.

Fixing the Market
Liquidity Drought

The cut of the discount rate is designed to tackle the
liquidity drought in the banking system and to keep banks liquid to
prevent financial
markets from seizure. The new policy statement
signals that the Fed stands ready to cut interest rates if necessary to
deal
with the contagion effects of the subprime mortgage generated liquidity
crisis
on the real economy. The objective is to restore the flow of funds
through the
banks into the financial system to limit the damage to the real
economy.
Whether intended or not, the Fed’s new policy stance sparked
speculation that
the European Central Bank, which injected over 150 million euros into
its
banking system in previous days, might be forced to back off raising
euro interest
rates in September to prevent the euro from rising further.

Up to the time of the discount rate cut on August 18, the
Fed had to repeatedly pumped liquidity ($52 billion) into the financial
system through
the repo market to keep the overnight Fed Funds rate from rising above
its
target of 5.25%. This Fed monetary market tactic has been described by
market
participants as the Fed practicing “stealth easing” or “synthetic
easing”; that
is, to inject funds without lowering the Fed Funds rate. But while the
Fed hoped
to restore liquidity to financial system with an injection of some $52
billion to
the overnight money market, this injection failed to impress the
market. Three-month
lending rates remained high and the asset-backed commercial paper and
jumbo mortgage
market remained dysfunctional. The stock market continues to fall after
a brief
reprieve.

Ready investors for debt instruments of all sorts have
become endangered species in this market seizure. The Fed is determined
to restore
liquidity in these seized markets to fulfill its mission of keeping
markets functioning. It also believes that the longer credit
markets
stay seized, the bigger the risk of disrupting the flow of credit to
households
and businesses in the economy to induce a recession or worse. Yet
moving
aggressively on the discount window front will ensure availability of
funds to
the banking system to keep banks solvent but it may not help to get
markets
working unless the Fed is prepared to drop massive amounts of dollars
from
helicopters on main street as Fed Chairman Bernanke once quipped before
becoming chairman.

The Fed has not changed the nominal rating level of
securities eligible for these operations even though the ratings have
been decoupled
from real market price of the securities. By reducing the penalty rate
on
discount window lending from 100 basis points over the federal funds
rate to 50
basis points, and allowing banks to obtain 30-day loans rather than
overnight
money, the Fed ensures that banks encountering difficulties securing
finance
against mortgage-backed and other collateral have assured access to
liquidity
at reasonable rates. And many banks are encountering such difficulties
as they
fail to find buyers in the debt market for the asset-back securities
they hold
as collateral for bank loans made to hedge funds and private equity
groups.

Central Bank
Impotence

But the time has long passed when central banks adding
liquidity to the financial system can help a liquidity crisis in the
market. When
the Fed injects funds directly into the money market through the repo
window, banks
and thrifts and other non-bank financial institutions that need funds
can
participate. With the daily volume of transaction in the hundreds of
trillions
of dollar in notional value of over-the-counter derivatives, the Fed
would have
to inject fund at a much more massive scale to affect the market. Such
massive
injection will mean immediate and sharp inflation. Worse yet, it will
cause a
collapse of the dollar.

When the Fed adds liquidity directly into the banking system
through the discount window, it injects high-power money into banks by
making
interest rate for overnight interbank banks loans within its set
target. The
theory is that banks will in turn be able to make loans at interest
rates
deemed appropriate by the Fed, thus relaying the added liquidity to the
market
in multiple amounts because of the mathematics of partial reserve.

But just because banks are able to make loans at low
interest rate does not mean banks can find borrowers with credit
ratings to
justify the low rates. John Maynard Keynes' concept of a liquidity trap
is that
market preference for cash positions can outweigh interest rate
considerations.
In a financial crisis, there may simple not be enough credit-worthy
borrowers
at any interest rate level and the number of sellers stay stubbornly
larger
than the number of buyers because sellers need to sell precisely
because they
do not have credit worthiness to borrow even at low interest rates and
buyers
stay on the sideline waiting for even lower prices.

Even when the Fed lowers the discount rate, banks will only see
their threat of insolvency reduced. Banks will still be sitting on
piles of
idle cash that they cannot lend. This is known as banks pushing on a
credit
string. Keynes insightfully observed that the market can stay
irrational longer
than most participants can stay liquid. Since central banks are now
mere market
participants because of the enormous size of the debt market due to the
wide-spread use of structured finance with derivatives whose notional
value
adds up to hundreds of trillion of dollars, the market can stay
irrational longer
than even central banks can stay liquid, if central banks do not want
to drive
their currencies to the ground. With deregulated global financial
markets, central
bank capacity for adding liquidity to the banking system is constrained
by its
need to protect the exchange value of its currency. For the US,
which depends on foreign central banks to fund its twin deficits, any
drastic
fall of the dollar will itself create a liquidity crisis from foreign
central
banks shifting out of dollar in their foreign exchange reserves.

Federal Reserve flow of funds data shows outstanding home mortgages in
Q1 2007
to be at $10.4 trillion. About $1 trillion in mortgages are due for a
reset by
the end of 2007 alone. A 4% reset of interest rates on $1 trillion of
mortgages
would require addition payments of $40 billion. Agency-and GSE-backed
mortgage asset
amounts to $3.9 trillion. Issuers of asset-backed securities home
mortgages
asset amounts to $1.9 trillion. The numbers are further magnified
hundred of
folds by structured finance with high leverage which magnifies the cash
flow
caused by even the slightest interest rate volatility. Liquidity
problem
associated with counterparty default could quickly run up to trillions
of
dollars. What does the Fed hope to accomplish with injecting a mere $50
or 100
billion in the banking system, except to show its impotence? The Fed
can keep
the banks from failing, but it cannot prevent the harsh reckoning of
the debt
bubble economy.

What is Market
Liquidity?

After all, what is market liquidity? Economists refer
frequently to liquidity in the abstract, yet in reality, liquidity is
difficult
to define and even more difficult to measure and almost impossible to
restore
because it is hard to know where the weak links are. On Wall Street,
liquidity
refers to the ability to buy or sell an asset quickly and in large
volume
without substantially affecting the asset’s price. Shares in large
blue-chip
stocks like General Electric used to be considered liquid, a
description long
since rendered invalid because of market volatility.

Of the several dimensions of market liquidity, two of the
most important are tightness and depth. Tightness is a market’s ability
to
match supply and demand at low cost (measured by bid-ask spreads)
quickly,
while market depth relates to the ability of a market to absorb large
trade
flows without a significant impact on prices (approximated by volumes,
quote
sizes, on-the-run/off-the-run spreads and volatilities). When market
participants raise concerns about the decline in market liquidity, they
typically refer to a reduced ability to deal without having prices move
against
them, that is, about reduced market depth.

Cycles of liquidity crises have been a recurring feature of
financial markets. Commonly used indicators of market liquidity are
notoriously
imperfect as reliable measures of liquidity conditions. While
conditions in the
autumn of 1998 were indeed identified as reflecting the adverse shock
of the
1997 Asian Financial Crisis to liquidity in financial markets,
liquidity
indicators seemed to suggest that, with the notable exception of the US
government
bond market, liquidity conditions were broadly restored to pre-crisis
levels
within a short period in the US. However, the usual indicators
typically
capture only a single dimension of market liquidity and none of them
were
forward looking in nature, making it difficult to draw any conclusions
as to how
long-term future liquidity conditions were being shaped by responses to
current
liquidity stress. Bubbles are the bastard children of liquidity
overshoots.

While idiosyncratic factors might be cited as being
responsible for the perception of low liquidity in specific markets,
reduced market
liquidity is unlikely to be a purely conjuncture phenomenon. From a
financial stability
perspective, some of the structural factors at work can be highlighted,
focusing on developments bearing on liquidity conditions in the
integrated
global financial system at three different levels, namely:

(i) Firms: developments at the level of major financial
firms participating in the core financial markets;
(ii) Markets: developments in the structure and functioning
of markets themselves; and

(iii) System: developments across the global financial
system as a whole, such as the systemic effects of credit derivatives.

Liquidity and Credit
Risks

Such structural developments may have served to reinforce
the links between liquidity and credit risks, but also the distinction
between normal
conditions and abnormal conditions and between normal times and times
of stress
when confidence declines. The current challenge
is one of returning an abnormal economy of excess liquidity to an
economy of
normal liquidity without extinguishing the flame of liquidity entirely.
The
period of stress will be the time it will take to work off the excess
liquidity, to turn the liquidity boom back to a fundamental boom. It is
not
possible to preserve abnormal market prices of assets driven up by a
liquidity
boom if normal liquidity is to be restored. All the soothing talk
about the fundamentals
of the economy being strong notwithstanding the debt bubble is
insulting to the
thinking mind. This is a debt economy fed by a liquidity boom. When the
liquidity boom turns to bust, all the strong fundamental indicators
such as
corporate earnings will wilt from a debt crisis. Asset value cannot be
held up
by simply adding excess liquidity forever without creating hyper
inflation.
Also, some liquidity problems, such as those caused by a loss of market
confidence,
cannot be solved by merely injecting money into the financial system
which in
fact will only add to the problem. Restoring market confidence requires
a
rational restructuring of the economy to absorb excess liquidity.

Liquidity Risks
Under-priced

Many market participants had felt that pre-LTCM (a major
hedge fund that collapsed in Sept 1998 from wrong bets on Russia
sovereign bonds
rising in value above US sovereign bonds) liquidity risk in many credit
markets
had been under-priced, and that the under-pricing led financial
institutions to
underestimate liquidity risks with a “liquidity illusion” mentality.
Such under-pricing
inhibited developments that would enhance the market’s ability to
retain
liquidity in times of sudden stress. There were indeed several
occasions since
the LTCM crisis, such as the September 2006 collapse of Amaranth
Advisors,
which lost nearly $6 billion in a single week after a highly leveraged
bet on
the future price of natural gas prices blew up, when conditions in some
markets
turned adverse but liquidity, which typically declined sharply in the
midst of
the crisis, proved to be rather resilient.

The
trading
strategies employed by LTCM's highly leveraged
portfolio were generally uncorrelated with each other in order to
benefited from diversification. However, a sudden rise in liquidity
preference in the market in late summer of 1998 led to a sharp
marketwide repricing
of all risk leading these positions to all move in the same direction.
As the correlation of LTCM's positions increased, the diversified
aspect of LTCM's portfolio vanished and large losses to its equity
value occurred. Thus the primary lesson of 1998 is more than one of
liquidity which the the effect rather thn the cause of the crisis.
Fundamentally, it was a problem of paradign shift that changed the
underlying Covariance Matrixused in Value at Riak (VaR) analysis
fromstattic to dynamic.

The high
leverage employed by the LTCM in order to maximize gain made it highly
vulnerable to volatility and credit risk even though the logic of
LTCM's
directional bets was valid in thinking that the values of government
bonds
should converge. But the high leverage deprived an
undercapitalized LTCM the luxuary of needed staying power to benefit
from the eventual convergence.

Hidden Relays of
Counter-party Risk

However, some elements of recent developments, such as widespread
financial consolidation, the increasing use of non-government and
synthetic securities,
particularly collateralized debt obligation (CDO) instruments, as
hedging and
valuation benchmarks, might influence the behavior of market
participants in a
way suggesting that market dynamics in times of extreme stress can
change significantly
and abruptly. This has heightened concerns about credit risk,
particularly the hidden
relay of counter-party risk, which can undermine market participant
willingness
to enter into transactions and thus weaken market liquidity in market
environments
of heightened uncertainty. Other elements, such as aggressive
collateralization
practices and overdevelopment in risk management policies, which
generally
enhance market stability in normal times, could add pressure in times
of
extreme stress.

Price as a Function
of Liquidity

Price is a function of liquidity which can be quite detached
from normal value. Liquidity conditions offer a new paradigm as the key
to
understanding why and how the markets move. Liquidity is consistently a
reliable indicator on which to base the timing of trading and
investment
decisions. Liquidity is the key determinant of the direction of the
stock
market, but it does not inform on fundamental value. The aggregate
capitalization of any market or market sector, whether stocks, real
estate,
precious metals, commodities, debt instruments etc., is a function
primarily of
liquidity, with the economic value having only secondary impacts except
when
liquidity is neither excessive nor scarce. The total value of any
market is
impacted by its current liquidity trend as technical analysts know.

Changes in The
Trading Float

Liquidity can also been measured by the relationship between
changes in the total trading float of shares or debt instruments in the
entire
stock and credit markets and the change in cash available for
investment. Market
liquidity has two components: the change in the trading float and the
change in
the cash available to buy. Liquidity analysis, in essence, is measuring
change
in the trading float of assets and tracking the movement of cash.

For the equity market, some analysts offer a daily liquidity
number (Daily Liquidity Trim Tabs) that is determined by adding US
equity fund
inflows, 2/3 of newly announced cash takeovers, 1/3 of completed cash
takeovers
and subtracting new offerings. Their longer term analysis of the
underlying trends
in liquidity takes in account stock buybacks, insider selling and
margin
debt. Mutual Fund Trim Tabs survey over
eight hundred and fifty equity and bond funds daily. US
stock market liquidity looks at flows into equity mutual fund that are
not
international specific. International equity and bond funds flow are
determined
separately. Trim Tabs Market Capitalization Index measures the market
value for
all NYSE, NASDAQ and AMEX stocks. The AMEX is included but not listed.
Trim Tabs
Market Cap Index does not include ADR’s.

Liquidity and Income
Distribution

Liquidity analysis starts with the overall economy’s cash
flow. The best way of watching US cash flow is daily and month income
tax
collections. Higher income tax collections suggest higher incomes. The
Internal
Revenue Service reports that while incomes have been rising since 2002,
the
average income in 2005 was $55,238, nearly 1% less than in 2000 after
adjusting
for inflation. The number of tax payers reporting income of over $1
million
grew by 26% to 303,817 in 2005 from 2000. This group, representing less
than
0.25% of the population, reaped 47% of total income gain in 2005
compared with
2000. This group also received 62%of the tax savings on long-term
capital gain
and dividends of the 2003 Bush tax cut. Those making over $10 million
received
tax savings of nearly $2 million each. This group enjoyed a tax saving
of $21.7
billion on their aggregate investment income. Some 90% of the working
population made less than $100,000 in 2005. They received $318 each on
average
in tax savings from investment. Nearly 50% of the working population
reported
income of less than $30,000. Liquidity
in US markets is driven by debt, not income, and most of the debt is
sourced
from foreign central banks.

Liquidity and Market
Capitalization

The conventional "value" paradigm says that the
overall market capitalization is a function of the growth of aggregate
cash
flow of all stocks, and that the stock market discounts future
earnings. This has
never worked in reality. Market capitalization derived from price
levels is always
a function of liquidity as it is almost impossible for any central bank
to
match money supply growth with economic growth perfectly in the short
term.

The conventional value paradigm is unable to explain why the
market capitalization of all US
stocks grew from $5.3 trillion at the end of 1994 to $17.7 trillion at
the end
of 1999 to $35 trillion at the end of 2006, generating a geometric
increase in
price earnings ratios and the like. Liquidity analysis provides a ready
answer.
Between the end of 1994 and the end of 1997 the trading float of shares
shrank,
and from early 1998 through the end of 1999 the trading float was
unchanged. Over
those same five years the amount of money looking to buy that shrinking
or
stagnant pool of shares kept growing. The result was that market cap
kept
rising regardless of economic value, with a stock market up more than
over
three times in five years. It is a clear
evidence of the Quantity Theory of Money at work. It is called a
liquidity boom,
which also fed the housing bubble in the recent years.

Money Flow and
Liquidity

Money flows from buyers to sellers. If the buyers retired
the shares or debt instruments purchased and the sellers, mostly
portfolio
managers, had to replace their holdings from a smaller market float
(the number
of shares outstanding in the market); that adds liquidity. If the
sellers vend
newly printed shares and used the cash for anything other than buying
other
shares; that reduces liquidity. If sellers suffer losses, liquidity is
reduced
by the transaction. A Federal fiscal deficit reduces liquidity,
particularly if
the spending is overseas, such as foreign war.

Liquidity and the
Impact of News

Liquidity determines how strongly news will affect stock
prices. Positive liquidity can spur the market significantly higher
when other indicators
are positive and cushion the fall when those indicators are negative.
Conversely, negative liquidity can dampen the effect of good news. When
liquidity contracts on hopeful news, as the current market indicates,
risk
aversion is the driving force. Liquidity almost always stays in step
with the
market and visa versa.

Keynes' Concept of
Liquidity Trap

For an economy subject to business cycles, the lower the
present rate of interest, the larger, ceteris paribus, would be a
future rise,
the larger the expected capital loss on securities, and the higher,
therefore,
the preference for liquid cash balances. As an extreme possibility,
Keynes
envisaged the case in which even the smallest decline in interest rates
would
produce a sizable switch into cash balances, which would make the
demand curve
for cash balances virtually horizontal. This limiting case became known
as a
liquidity trap.

In his two-asset world of cash and government bonds, Keynes
argues that a liquidity trap would arise if market participants
believed that
interest rates had bottomed out at a “critical” interest rate level,
and that rates
should subsequently rise, leading to capital losses on bond
holdings. The inelasticity of interest rate
expectations at a critical rate would imply that the demand for money
would
become highly or perfectly elastic at this point, implying both a
horizontal
money-demand function and LM (liquidity preference/money supply)
curve. The monetary authority, then, would not be
able to reduce interest rates below the critical rate, as any
subsequent
monetary expansion would lead investors to increase their demand for
liquidity
and become net sellers of government bonds. Money-demand growth, then,
should
accelerate when interest rates reach the critical level.

Keynes argued that there were three reasons why market
participants hold money. They hold cash for pending transactions
purposes,
which is what the quantity theory had always said. They also hold money
for precautionary
reasons, so that in an emergency they would have a ready source of
funds.
Finally, they hold money for speculative purposes. The speculative
motive arose
from the effects of interest rates on the price of bonds. When interest
rates
rise, the price of bonds falls. Thus when people think interest rates
are
unusually low, they would prefer to hold their assets in the form of
money. If
they invested in bonds and the interest rate rose, they would suffer a
loss.
Hence the amount of money market participants would want to hold should
be
inversely related to the rate of interest. Market participants will
want to
hold more money (liquidity) when interest rates are low than when they
are
higher, despite a loss of interest income.

Keynes’ introduction of the interest rate into the demand
for money has survived in modern finance, but not for the reasons he
gave.
Keynes was thinking in terms of a two-asset world: money, which earned
no
interest but which was liquid and had no danger of a capital loss, and
bonds, which
earned interest but which were not as liquid and which has a risk of
capital
loss. If one thinks not in terms of a two-asset world, but in terms of
the
range of assets which actually exist in the current financial world,
there is
no reason to hold cash balances for either precautionary or speculative
purposes. These are assets that are both very liquid and interest
bearing, such
as money market accounts and Treasury bills, plus all forms of options
in
structured finance.

Though Keynes' two-asset-class explanation of why interest
rates influence the demand for money is outdated by developments, his
other explanations
are still sound. Money held for transactions purposes is much like
inventory
which businesses hold. A rise in interest rates will decrease the
optimal amount
of money as inventory, and a rise in the cost of re-monetizing will
increase
the optimal amount. Modern management has introduced just-in-time
inventory
which renders this argument mute. Most chief financial officers have
also
perfected just-in-time cash management schemes. The exception is that
holders
of money can live on it, which is not true for holders of most other
inventories.

Liquidity and Money
Velocity

When market participants hold cash balances, they may no
longer hold their assets in a form that earns no interest, yet interest
rates
does generally tend to increase with less liquidity. If interest rates
rise on
non-money assets relative to money, the cost of holding money in terms
of
interest foregone rises, and one would expect market participants to
try to
economize on cash. A business, for example, could shift money from
checking accounts
into treasury-bills, or resort to loans instead of selling assets with
high
future value. It would be worthwhile to make more transactions into and
out of interest-bearing
assets to take advantage of the higher interest rates. When interest
rates are
very low, these transactions may not be worthwhile, and the business
may be
willing to let money lie idle for short periods in checking
accounts. High interest rates thus increase the
velocity of money. Interest payments do not disappear from the system;
they go
into the lenders’ pocket thus increasing liquidity. A liquidity trap
tends to
develop in a price deflation environment.

Liquidity and
Monetization of Assets

Liquidity is the ability to monetized assets without causing
prices to fall. Liquidity thus depends on more than just the
availability of
cash. It depends also on the availability of demand for assets, i.e.
willing buyers.
A liquidity crunch can develop even if there is plenty of zero-interest
rate
cash in buyers’ pockets but every buyer is waiting for lower prices,
causing
assets to be illiquid, i.e. unable to be monetized without lowering
prices. It
can also develop if buyers lose confidence in the future of the
economy. Distressed
assets cannot exit to cut losses at any price and they bring down
prices of even
otherwise good assets. This is what causes contagion which can start a
downward
spiral of self-fulfilling fear.

Liquidity and Money
Depreciation

The ultimate effect of central banks injecting money into
the banking system is the depreciation of money which now is fiat
currency in
all countries. When the European Central Bank (ECB) injects euros into
its
banking system, the euro will fall against other fiat currencies,
including the
dollar, forcing the Fed to also inject money into the US
banking system. This can quickly turn into a competitive currency
depreciation
game. For all central banks facing a liquidity crisis, the option is a
market
crash or a currency crash, or if central bankers are not careful, it
can easily
become a crash of both equities and currencies.

Unpaid Debt Destroys
Economic Value

When debts are not repaid, financial value is destroyed
which will be expressed in falling asset prices. This loss of
value will need to be reckoned in
the economy. When individual market participants lose in a normal
transaction,
other participants normally gain from their losses. But when value is
lost by
debts unpaid, the creditor loses while the debtor gains by reducing his
liability. And if default debtors are bailed out as a class by the
central
bank, the issuer of money, creditors as a class lose relative to their
position
to debtors before debtor default, albeit the face value of the loss is
reduced
by the amount of the bailout. The cost of the debtor’s virtual gain and
the
reduced loss suffered by the creditor is passed onto the financial
system by
the central bank bailout. It is more
than a moral hazard problem of encouraging debtor future adventurism.
The
economy actually pays by accepting excess liquidity and financial
friction
against real growth.

Falling prices can be slowed down somewhat by the
depreciation of money but only up to a point, after which worthless
money can
add to the fall of real asset prices after inflation. That point is
dangerously
near at this very moment in the global economy to usher in a period of
sustained
deflation. The Federal Reserve added $52 billion in temporary funds to
the money
market through the repurchase agreement of securities including
mortgage-backed
debt to meet demand for cash amid a rout in bonds backed by home loans
to risky
borrowers. The Fed’s additions were the biggest since the September 11, 2001 terrorist
attacks. The
additions came in three repo transactions of $19 billion, $16 billion
and $3
billion. Losses in U.S.
subprime mortgages have been rippling through credit markets, driving
interest
rates higher and sinking stocks and seizing credit markets.

The Fed accepted mortgage-backed debt issued or guaranteed
by federal agencies, so-called agency debt and Treasuries as collateral
for the
repos. Normally, the Fed does not
accept mortgages as collateral for repo transactions but the move
signals an
attempt by the central bank to alleviate financing fears. Wall Street
dealers
are seeking the sanctuary of government bonds and are trying to sell
their
holdings of riskier assets such as mortgages if buyers can be found.
Until
then, they may keep going to the repo market for overnight funds.

Hedge Fund Woes

In the past three weeks, the computer models that some hedge
funds use to make trades to implement their strategies have been
victimized by
paradigm shifts. These models typically scan markets to spot tiny price
discrepancies under normal conditions, and then place highly leveraged
large
orders to capture gains that add up to outstanding returns on capital.
With
unusual market volatility and disorderly markets, highly leveraged
hedge funds
can face margin calls from brokers that develop into fire sales of good
assets
in their portfolios.

Hedge funds with market-neutral strategies have been
wagering on high-quality stocks, or stocks that trade at low valuations
based
on various metrics, and betting against stocks that appear overpriced.
The relatively
conservative approach enables traders to feel comfortable in using
leverage to
boost returns. With unexpected margin calls from banks, were forced to
sell
their holdings of high-quality stocks to raise cash, and closed out
short
trades by buying back shares of companies identified by models as
overpriced.
Others sold positions simply to become more conservative, in a volatile
market.

Since market-neutral funds often are guided by similar
computer models and share similar holdings, the actions magnified moves
in
asset prices. Funds that are normally pillars of stability in normal
markets
become detonator of instability in disorderly markets.

Concern Shifted from
Hedge Funds to Banks

However, the Fed’s actions reflected a shift of the focus of
concern from hedge funds towards banks who loaned the hedge funds money
to
trade with leverage. Banks are also exposed to the problem of having
committed credit
lines to financial institutions with subprime exposure, such as
mortgage
lenders or specialist investment vehicles. Banks have also arranged
loans to
risky firms such as buy-out groups, which they had planned to sell into
a debt
market that had evaporated overnight. An
estimated $300 billion of unsold loans are sitting on bank balance
sheets,
gobbling up funds pushing up reserve requirements. Banks themselves are
facing
problems raising funding in the money markets where investors are very
nervous
about lending money to anybody who might be potentially exposed to
subprime
losses. And since it is hard to know who is holding subprime exposure,
because
these securities have been scattered around, banks are being
blackballed in an indiscriminate
fashion. The is a confidence problem that the Fed cannot do much about,
short
of offering to buy worthless securities that even a liquidity boost
cannot
restore fully.

Commercial Paper
Crisis

In the US,
asset-backed commercial paper, which comprises about $1.15 trillion of
the
$2.16 trillion in commercial paper outstanding, is bought by money
market funds
with conservative investors. The cash enables some selling entities to
buy
mortgages, bonds, credit card and trade receivables as well as car
loans. The commercial-paper market, a critical
source of short-term funding for an array of companies, was becoming
inaccessible for a growing number of companies since the beginning of
August.
There were also signs of trouble in parts of the currency market. The
asset-backed
commercial paper market, a crucial arena where financial institutions
raise
funds, has had no buyers in recent days.

This has been a recurring problem in this debt economy. On March 13, 2002, GE Capital
launched a
multi-tranche dollar bond deal that was almost doubled in size from $6
billion
to $11 billion, making it the largest-ever dollar-denominated corporate
bond
issue up to that time. Officially the bond sale was explained as
following the
current trend of companies with large borrowing needs, such as GE
Capital,
locking in favorable funding costs while interest rates were low. On
March 18,
Bloomberg reported that GE Capital was bowing to demands from Moody's
Investors
Service that the biggest seller of commercial paper should reduce its
reliance
on short-term debt securities. The financing arm of General Electric,
then the
world’s largest company, sought bigger lending commitments from banks
and
replacing some of its $100 billion in debt that would mature in less
than nine
months with bonds. GE Capital asked its banks to raise its borrowing
capacity
to $50 billion from $33 billion.

Moody's, one of two credit-rating companies that have assigned GE
Capital the
highest "AAA" grade, had been increasing pressure on even top-rated
firms to reduce short-term liabilities since Enron filed the biggest US
bankruptcy on December2, 2001. Moody's released reports analyzing the
ability
of 300 companies to raise money should they be shut out of the
commercial paper
market. GE Capital and H J Heinz Co said they responded to inquiries by
Moody’s
by reducing their short-term debt, unsecured obligations used for
day-to-day
financing. Concerns about the availability of such funds have grown
that year
after Qwest Communications International Inc, Sprint Corp and Tyco
International Ltd were suddenly unable to sell commercial paper.

Moody’s lowered a record 93 commercial paper ratings in 2001 as the
economy
slowed, causing corporate defaults to increase to their highest in a
decade.
One area of concern for the analysts was the amount of bank credit
available to
repay commercial paper. While many companies had credit lines
equivalent to the
amount of commercial paper they sell, some of the biggest issuers did
not. GE
Capital, for example, had loan commitments backing only 33% of its
short-term
debt. American Express had commitments that cover 56% of its commercial
paper.
Coca-Cola supported about 85 percent of its debt with bank agreements,
according to Standard & Poor’s, the largest credit-rating company,
which
said it was also focusing more attention on risks posed by short-term
liabilities.

In the first half of 2002, companies sold $107 billion of
investment-grade
bonds, up from $88 billion during the same period in 2001. The amount
of unsecured
commercial paper outstanding fell by a third to $672 billion during the
previous
12 months. PIMCO director Bill Gross disputed GE’s contention that the
company’s
new bond sales were designed to capture low rates, but because of
troubles in
its commercial paper market. If the GE short-term rate rises because of
a poor
credit rating, the engine that drives GE earnings will stall. Gross
dismissed GE
earning growth as not being from brilliant management, former GE
chairman Jack
Welch's self-aggrandizing books not withstanding, but from financial
manipulation: taking on debt at cheap rates and using inflated GE
stocks for
acquisition.

GE had $127 billion in commercial paper as of March 11, 2002. That amounted to 49%
of its total debt. Banks credit lines only covered one-third of the
short-term
exposure. GE capital core funds itself by borrowing commercial paper
from
investors in the marketplace, and the interest payments that it pays on
those
commercial paper instruments give it floating rate exposure, because
they turn
over frequently, short duration.

In Q4 2006, GE total commercial paper balance was a little
over $90 billion, a quarter of its financing. GE makes loans to
customers, and
a significant part of its loans to customers include fixed rate
payments of
interest. So to match fund its assets, to have fixed rate interest
costs to go
with the fixed rate interest income, GE enters into a basis interest
rate swap.
GE offsets the floating interest rate exposure to the CP and pays a
fixed rate
of interest to the swap counter-party to match funds its asset.

As of June 30, 2007,
the US Corporate Bond Market totaled $3.7 trillion in outstanding par
value
split 82% investment grade and 18% speculative grade. Across the pool
of
industrial bonds, the par value share of issues rated speculative grade
is
substantially higher at 31%. The par value of bonds maturing through
the end of
2007 totals $194.9 billion. The bulk (95%) of this volume ($186.0
billion)
consists of investment grade bonds with the remaining volume ($8.9
billion)
residing at the speculative grade level.

Commercial paper outstanding fell $91.1 billion in the week
ended Aug. 15 to a total of $2.13 trillion, a weekly plunge that
captured both
bond and stock markets attention. The
data, released on the Federal Reserve Board Web site, validated the
trend that
issuers were being forced to make orderly exits from the commercial
paper
market to obtain financing elsewhere.

CDO Illiquidity

Collateralised
debt obligations (CDOs) are designed to let some high-risk tranches
take the
first loss if any of the underlying debt defaults, while other “senior”
securities only suffer losses after the riskier tranches are wiped out.
In a
typical CDO, senior securities can achieve credit ratings much higher
than those
of the underlying debt, sometimes triple-A, the same rating as US
government
securities. The catch is that many CDO securities are infrequently
traded and
some are tailored by investment banks for specific clients, such as
pension
funds, and have never traded. Without a market price, valuation
involves
complex computer models and subjective assumptions. The credit crisis
will hit
the pension funds; it is merely in a matter of time.

Bear Sterns in
July revealed large losses at two hedge funds that owned
subprime-related CDOs,
but had trouble quantifying the losses. Attempts to sell the
instruments ran
into trouble because few traders offered anything except very low,
fire-sale
prices.

This raised
questions over whether hedge funds, investment banks and even pension
and
insurance groups know the market value of their structured credit
holdings. As
a result, the CDO market is closed, and access to credit, especially
for
leveraged buyout debt, has been severely curtailed. The news that BNP
Paribas
was suspending three funds underlined the valuation problem caused by a
liquidity drought in the market.

Some senior US finance
officials calculate losses in the subprime-related sector to be a
containable
$100 billion. The market seems to have a different opinon. The impact
from
uncertainty is now spreading to affect other debt markets, such as the
corporate
bonds and commercial paper market. That is creating severe trading
losses and destroying
confidence.

The Politics of
Bailouts

Politicians are
talking about taking measures to help households suffering from the
subprime
crisis to prevent as many as 3 million largely low-income households
from
losing their homes. However, that will not solve the crisis in the
financial
markets. In fact it may add to it. But with the central banks pumping
in money
to help banks from failing, while families are evicted from their homes
is very
bad politics in a election year. The central banks are giving financial
institutions whose credit rating and cashflow are not much better than
family
with subprime mortgages, free credit cards with a subsidised interest
rate and
no spending limit for as long as needed, while these very same
institutions are
foreclosing on the homes of their customers. This crisis will likely
build to a
crescendo just before the November presidential election. Its going to
be a
very interesting election. Will the credit crisis of 2007 usher in an
age of
popularism in US politics?